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Reorganising foreign companies in China

Out-Law Guide | 08 Aug 2013 | 10:03 am | 4 min. read

This guide was last updated in August 2013.

As China-based companies with foreign owners or investors expand or as trading conditions change they will want to re-organise. This guide outlines the factors they should take into account in that process.

Companies might have grown quickly and might find themselves with a web of enterprises that are complex and difficult to control; or perhaps companies have to change how they operate to take advantage of China's move away from low-cost manufacturing and towards a situation where significant local presence is necessary to gain significant shares of local markets.

Whatever the factors leading a company to take a fresh look at the set up of its enterprise groups in China, a reorganisation should be conducted in phases, as set out below.

Assessment of current situation

First, a company’s present status must be assessed from the commercial perspective. What group structure has evolved over the years? Are there inter-company activities like shared services which may not be in full compliance with China's laws and regulations? Is there a joint venture partner who is no longer supportive and a drain on energy due to different views on strategy or compliance?

Using questionnaires and management interviews in China and if necessary at global headquarters level the company should identify and profile the restructuring needs. At this stage legal and tax aspects should not yet be the main driver of developing new concepts. The main objective is to identify the commercial objectives of a potential intra-group reorganisation, which may comprise a simplified structure, reorganized and streamlined processes, cost savings, etc.

Reorganisation concept

Once you have identified your commercial objectives, you can identify and explore legal options. There are a variety of tools that may be used including mergers, divisions, hive-downs, buy-outs of joint venture partners, relocation of a factory to a more cost efficient site, asset transfers, downsizing, or liquidation of companies, including solvent liquidation and bankruptcy liquidation. Sometimes it makes sense to establish a holding company, or at least a management company, if incentive schemes for regional headquarters exist, though financing can be a tricky issue.

These commercial objectives must be measured against legal and practical feasibility. For instance, a relocation across provincial borders or the establishment of a branch in another province may be theoretically and legally feasible. But often it does not work because local authorities want to either improve investment statistics or secure tax payments in their districts. The result is that they only approve legal entities and do not support branches of companies located in another province.

These legal options must also be checked against tax effects. There are often hidden tax risks. For example foreign investors may expect that an inter-group reorganisation can be conducted at book values. While Chinese tax regulations do permit special tax treatment (STT) of such reorganisations on paper and under certain conditions, it may be difficult to secure the STT status as Chinese tax authorities are reluctant to act and approve the STT treatment in the absence of clear internal guidelines. This ultimately hinders the reorganisation process. 

Also, transfer pricing issues may arise in the course of a reorganisation that affects the transfer of assets and intercompany services. Finally, the potential repayment of tax incentives and subsidies has to be considered as they can cause considerable restructuring costs. If a company is to be liquidated in the reorganisation, any tax non-compliance would be likely to resurface during the tax authority’s audit. The group’s post transaction structure should also be considered beforehand so that the reorganisation does not negatively affect the entire group’s tax efficiency.

A reorganisation may raise a number of other issues. For example, employees are not always prepared to relocate to a less attractive location. It may be necessary to provide severance payments. In some situations it is necessary to negotiate voluntary arrangements. In particular, group internal transfers of a business through an asset deal may be difficult if employees invoke their rights under the labour laws and regulations.

It may also be impossible to transfer a valid operating license to a new group entity. For example a registration with the State Food and Drug Administration (SFDA) attached to a producer of pharmaceutical drugs cannot be transferred and a new entity taking over the business may have to go through very time-consuming re-registration proceedings. 

To address all these issues properly, it is often necessary to organise one or several workshops and conduct interviews on departmental levels. At the end of this phase a number of options for the intra-group reorganisation should emerge which must be discussed with the local and global management.

Once management decisions have been taken, the direction of the intra-group reorganisation should be clear and a detailed Reorganisation Concept can be developed.

Implementation

Implementing an intra-group reorganisation can be cumbersome. Further, it is often a 'moving target' due to the constant changes in the regulatory regime and the administrative practice of the authorities. It is therefore important to develop a concise project plan with milestones, tasks, responsibilities and timelines that is flexible enough to allow for adjustments.

The project plan should include enough time to discuss the implementation with the various authorities involved at various stages. They usually have discretion when deciding whether or not to approve specific elements of an intra-group reorganisation. If communication goes wrong, they may be in a position to block a project. Usually, when various authorities are involved in a reorganisation project, the explanation of what is happening should be consistent between them.  

Finally, it has proved useful to conduct a project assessment on completion to discuss lessons learned, record open or new issues which may have to be covered by future projects, or to record risks which could not be mitigated and need to be monitored. Often the management will also expect a final project report.

Dr. Bernd-Uwe Stucken is a China-based lawyer with Pinsent Masons, the law firm behind Out-Law.com